The U.S.-China trade war continues to escalate with the addition of an alleged currency manipulation by the Chinese government. It’s the latest in a long list of actions and reactions by both nations, and the stakes are escalating. 

For most industrialized nations, currency is allowed to “float,” meaning that exchange rates vary in response to market conditions. The value is driven by supply and demand for the currencies of specific nations and whether individuals, businesses, and governments decide to buy, hold, or sell them. Economic growth and stability and low inflation tend to strengthen currencies, while inflation and poor performance or a weak institutional framework often weaken them. The decisions of monetary authorities also come into play.

Strong is not necessarily better. If the dollar strengthens compared to other currencies, it makes U.S. goods less competitive on world markets as more pounds, yen, or euros are needed to purchase them. On the other hand, a strong dollar makes imported goods less expensive to Americans. 

While there are clearly economic and political reasons a nation would want its currency to strengthen or weaken, it violates the precepts of free markets and G-20 accords to purposefully manipulate exchange rates. Instead, rates can only be influenced indirectly through policy actions such as those used at times to keep inflation under control. 

The Chinese central bank is not independent, however, and while it had been allowing the currency to fluctuate relative to the dollar within a range, the yuan was recently allowed to fall to its lowest level against the dollar in more than a decade. One dollar now purchases more than seven yuan, surpassing the prior target according to Chinese policy, and an 11 percent drop in a single day was particularly problematic. Chinese goods have suddenly become less expensive to importers and consumers around the world. In fact, the devaluation of the currency has wiped out part of the effect of U.S. tariffs; while the tariffs increased the cost of Chinese goods, the weaker yuan makes them cheaper. 

Reaction by the U.S. Treasury Department was swift, with a statement officially labeling China a “Currency Manipulator” and indicating that Secretary Mnuchin will “engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” The Chinese government has since indicated that it would not let the yuan fall further. The move led other central banks to implement rate cuts. 

The risk to China is that more expensive imports will compound the problem of a sluggish economy, but the hope is that it will force the US to the bargaining table. For the U.S., exports are now less competitive in world markets. There is nothing good about a trade war.